A question many investors face is where to invest for sources of income in a low yield environment. With the Reserve Bank of Australia (RBA) cutting the official cash rate by 0.25% to 2.0% in May, many investors are looking for income opportunities outside of term deposits. In this article, we discuss corporate bond investing as a way to access the benefits of diversification as well as a higher income return than what is currently on offer from term deposits and government bonds.
4 reasons to consider investing in corporate bonds
For investors looking to source income with stability, corporate bonds present a compelling investment opportunity. And for those who have ongoing liquidity requirements, this can be provided effectively through an actively managed corporate bond fund. Below are some key reasons for considering corporate bonds as part of a diversified portfolio.
- A strong buffer against share market volatility
Corporate bonds offer relatively stable cash flows and may be considered a lower risk way of gaining exposure to corporates than investing in equities. Since corporate bonds and Australian equities often move in opposite directions to one another, an allocation to corporate bonds can add to the defensive properties of a diversified portfolio.
- Offer higher income than term deposits and government bonds
The excess yield offered by corporate bonds over term deposits and government debt is expected to remain relatively high over the medium-term, providing an ongoing source of enhanced income for investors. Moreover, given sound company fundamentals, corporate bonds are well positioned in the current economic backdrop and can benefit from further economic recovery.
- Risk of capital loss is minimised
Active bond managers will commonly adjust a bond portfolio’s duration which measures the sensitivity of a bond portfolio’s capital value to a change in interest rates. Put simply, the duration will determine how long, in years, it takes for the price of the corporate bond to be repaid by its internal cash flows. This is important because generally speaking, corporate bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. By managing the fund’s duration, an investment manager can aim to limit the risk of capital loss in a rising interest rate environment.
- Gain access to the benefits of diversification
In an actively managed, corporate bond fund, investors are able to spread their portfolio risk by being exposed to a range of issuers, industries and geographies. Typically, when investors have exposure to a large number (upwards of 100) of securities the likelihood that a default or systemic event will have a major impact on the portfolio is minimised.
Diversification across varying levels of investment grade corporate bonds continues to pay rewards, with the BBB-rated sector in particular performing well recently. We continue to prefer Australian and US corporate bonds due to their economic fundamentals, with a bias toward defensive or non-cyclical industries.
Overall, corporate bond investing offers investors a way to access the benefits of diversification as well as a higher income return than what is currently on offer from term deposits and government bonds.
Our position on corporate bonds
We have received several queries over recent months in relation to sell-off of Government bonds, particularly in this US and Germany, and what this means for corporate bonds as well as any associated headwinds in market liquidity. The key to the market backdrop has been an ebbing of the forces that pushed prices higher towards the end of 2014. That is, commodities and the US dollar have stabilised and this has helped stabilise short-term inflation expectations. From here we feel any sustained fall in bond prices will require stronger global real activity data.
A lack of liquidity in a rising rate environment is certainly a consideration. In order to prudently reduce the exposure to interest rate sensitivity, we reduce the duration (thereby minimising the risk of capital loss) in our actively managed portfolio of corporate bonds.
How we plan to manage ongoing uncertainty
The use of credit derivatives allows us to hold onto quality bonds, amidst volatile markets. For example, we recently bought credit protection against a part of our corporate bond portfolio to temporarily reduce our market exposure amidst the Greece uncertainty. Due to the number of safeguards in place from the European Central Bank and national regulators we don’t see Greek contagion risk as being as severe as in previous periods. Accordingly, we will actively manage ongoing uncertainty and look to add corporate bonds during times of heightened volatility as we still like the underlying global policy support and corporate fundamentals.
On the whole, we are still constructive on corporate bonds and believe the low yields globally will continue to support the ‘search for yield’. This is not the end of the credit cycle because rates will ultimately respond to real activity improvements and views on inflation expectations, but the transition from quantitative easing in the US may see higher volatility, which supports active management strategies. In the short term, however, we expect technical forces to dominate, that is, the strong ongoing bid for corporate bonds. The next leg of the cycle will be more about stock selection and sector rotation as opposed to just being invested in credit. Given the depth and breadth of our credit research team we believe we are very well placed to continue to deliver on our monthly income promise and preserve capital.
Corporate bonds are traditionally considered lower down the risk spectrum than shares. Nevertheless, when exploring income investing from corporate bond issuance it is prudent to have a focus on investment-grade credit. While the search for yield leaves many investors with choices surrounding how much risk to carry, it is important to invest in companies with strong or improving corporate fundamentals, a solid management team with a bondholder focus, whereby a normalisation of global growth could translate into revenue and earnings growth.
Find out how corporate bonds can form part of your goals-based investment portfolio - Read more.